The market volatility is up by 240%YoY, while
volumes have shrunk by 57% YoY. With PTCL privatization still under
siege by employee unions, and uncertainty regarding the budget still
looming at large, we believe that the market is likely to further
decline. Our telecom analyst, Usman Farooqui came up with a Red flag
on this employee-management tussle, which indeed has proved to be very
much true. The employee union, which has strength of 45000, is
demanding around PkR12bn for VSS. If the potential bidder has to pay
this price, it would depress the fair-value by around PkR3 to PkR71.
The employee tussle can even scare the potential investor away, or
depress the potential bidding price. We advice our investors to stay
away from Pak Telecom, as the uncertainty surrounding privatization
can aggravate market volatility. The domestic law and order situation
is also not favorable.

Last week, there were unfortunate incidents of
sectarian violence, which have brought the city of Karachi under
stress. Next week would be extremely critical for the capital market,
with a budget, a t-bill auction and PTCL bidding date all coming in
the same week. We advice investors to remain away from the market to
avoid the uncertainty associated with these events. We recommend our
clients to cherry pick under-valued stocks. Our selection is National
Bank of Pakistan, Pakistan Oil Field, Fauji Fertilizer and Pak Suzuki
Motor Company. This portfolio would diversity investment risk.

A WEAK MARKET

Last week, we presented our investment strategy to
a local mutual fund. We advised our client, to stay sideline from the
market until Aug-05 as we expect the market to remain under pressure
due to 1) phasing out of COT 2) Deepening of CVT 3) Privatization risk
and 4) High interest rates. We expect, that by June-05, the government
would have to go for a PIB auction in order to meet its revenue
requirements for FY06. The coupon rate on the 10-year PIB is likely to
increase to the range of 10.5% to 11% in this auction. The increase in
the risk free rate makes equities a less attractive option at the
moment. We expect the interest rates to start declining by October-05,
and till then we expect the market to remain under pressure.

As the graph below shows, the market volatility, as
measured by standard deviation, has increased by a massive 240%YoY.
The fundamentals seems to have taken a backseat as annual trading
volume as a percentage of free float is 1698% as compared to 123% for
GEM and 521% average for most markets (Source: Deutsche Bank). Annual
trading as a percentage of market cap is around 510% as compared to
74% for the GEM.

INVESTMENT RECOMMENDATION: CHERRY-PICK!

The struggle between the bulls and the bears is
likely to be dominated by the bears due to the confluence of negative
triggers. We advice our clients to utilize this depression to
accumulate undervalued stocks. To diversify risk we recommend,
National Bank of Pakistan (NBP, price target: PkR150) from the banking
sector, Pakistan Oil Fields (price target: PkR238) from the Oil and
Gas sector, Pak Suzuki Motor Company (PSMC, Price target 140) and
Fauji Fertilizer (FFC: Price target: PkR160). We believe in that
current market situation, the premium would be on stock selection.
Investors to stay away from the temptation of jumping in the
speculative run in Pak Telecom, which we believe is too risky.

PTCL UNDER SIEGE

The negotiations between the employee unions and
the Pak Telecom Management (acting as fall guys for the government)
are in a tailspin. There has been news of cases being lodged and
accepted in the Sindh High Court. A stay order in this regard could
delay the whole privatization process. On another front there are the
very potent threats by the employees, have induced the army to operate
the company assets. Then there is the government, which in an egoistic
state does not want to postpone the privatization of the company by
one day. Indeed the current projection of the issue has been
inadequate and we have managed to gather a consensus of opinion from
various stakeholders.

Employees: This group is vehemently opposed against
privatization. They are disgruntled with the situation relating to
what they refer to as cronyism in promotions. They have no doubt over
the government's seriousness about the issue, but believe that the new
management will not succeed in running the company without giving the
employees guarantees over job security and experience-based
promotions.

Employee Union Leaders: They have dropped all their
demands with regard to bonuses and salary increases. Now all they want
is the stoppage of the privatization process. Pak Telecom with around
fourteen employee unions and around 45000 members, including at least
10-12 members in each exchange have tremendous bargaining power when
united. Union sources indicate that a compromise may be reached if
significant VSS benefits are given.

Higher Management: The upper Management
understandably wants privatization to go through. It is, however,
skeptical over the actual success of the whole process. This is
probably in part due to its recognition of employee power with regards
to the operation of the whole infrastructure. The management over all
is in a conundrum of being in the firing line between the government
higher-ups and the employees. According to view we are getting from
the management, there is a 40% chance of the new management
successfully taking over the company, if it fails to satisfy the
unions.

Privatization Commission: Seems the most helpless
body of them all. Meetings between the Commission and the employee
unions are being constantly adjourned, due to the Privatization
Commissions, referral of most decisions to the higher-ups in the
government. This itself shows its inability to make decisions on its
part and the impending seriousness of the issue.

Bidders: We have tried to contact the front-runners
in the process (Singtel, Etisalat and Telekom Malaysia) and as
expected they are tight-lipped over how they would deal with the
issue. They however will be keeping a close eye on the developments on
this front and any untoward incident will affect the privatization
price. According to various sources, the companies have till now
agreed only to one year's job surety for every employee.

Privatization Risk: Our estimate of employee
restructuring costs comes to about USD 200mn and in that case the
companies will figure that amount into their bids, thus depressing the
bidding price. Add to it the worsening law and order situation and
political stability; our expected bidding price comes to about USD 1.3
per share. The first quarter, post-privatization, will be crucial in
ascertaining whether the foreign company can adjust in the environment
and whether restructuring incentives are sufficient for quelling the
employees' discontent. Our restructuring cost estimate of USD200mn
will cause about a PkR3 fall in its fair value. If the cost of
lay-offs is borne by the company, then this one-time expense would
entail a significant drop in EPS for FY06 by PkR2.35. This would also
depress the dividend yield, which we believe would stand at around 4%
in FY06.

We advise the investors to stay away from the
stock, and adopt a wait and see approach.

IN THE MARKET THIS WEEK

The market closed at 7213, up 12% since last week's
closing at 6467.15. After the dismal performance the previous week,
the market sprung back to higher levels as the fears that had been the
primary cause of last week's slide were allayed. This week's average
trading volume was higher than that of the last four weeks' and the
value traded remained in the higher range (USD 461 mn). The major
stocks traded were Pakistan Telecommunication Ltd. (PTC) and Oil and
Gas Development Company (OGDC). The week was spotted with major events
beginning with the sectarian violence culminating in eight deaths. On
the technical side, the market got a tremendous boost with the turn
around in the SECP-KSE relationship. The other event marker in the
week has been the aggravation of the PTC union-management relations.

After taking an 11% beating the previous week, this
week picked up on a technical correction. The investors taking
advantage of the lower values on vital scrips, drove the market up
with a bull drive. The market remained buoyed in the face of sectarian
violence which began on Monday evening. The positive driver for the
buoyancy was the National Refinery Ltd (NRL) privatization which
provided the market with added liquidity and with positive sentiments.
All stocks associated with NRL privatization; Attock Refinery Ltd (ARL)
and Pakistan Oil Field (POL) also picked up in value, driving up the
index. The rest of the week saw the fall-out from the suicide attack
and consequent turbulence witnessed on Monday. Muttahida Majlis-e-Amal
called strikes in protest of the murder of Jamat-e-Islami leader.
However, the market again remained buoyed with the lower COT/ Badla
rates in the market that day. However the major force in pushing the
positive sentiment was the outcome of the SECP-KSE board meeting. The
major fears that had plagued the market during the previous few weeks
were laid to rest as the limit on the future trading was increased
from 1% of free-float to 3% of free-float with expectation of the
eventual increase to 5% once the pre-trade verification has been
implemented. Additionally, the 100% cash margin requirement for
exposure exceeding PkR. 200 million was reduced to 50%. The week
closed with some profit taking which put a downward pressure on the
market. PTC fell 5%, reacting to the aggravation of union-management
tiff.

Outlook: Neutral to Negative. The upcoming week is
going to be vital for the market. Although the budget is expected on
Monday, there are rumors regarding delay in its presentation. Such a
move, together with the dim prospects of the union-management tiff in
PTC, spell negative for the index.

Please review the attached event calendar, as the investor
community will be keeping an eye on the corporate announcements in the
coming week.